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China RO Changes in March – The Full Implications
Op-Ed Commentary: Chris Devonshire-Ellis
Jan. 14 – China has dramatically changed its regulations concerning the operation of representative offices (ROs) in the country and these alterations are due to take effect from March 1 this year. They will alter the operational and financial effectiveness of using ROs in China considerably.
ROs make up some 50 percent of all foreign presence in China and the implications to them of these changes are immediate and profound. SMEs in particular operating ROs in China will need to assess their operational usefulness in light of these developments, and consider making plans for alternative structures. In this piece we highlight the complete picture concerning these developments and provide suggestions and tips for handling and adapting to this far-reaching regulatory upheaval.
What the regulations say
The Chinese State Council issued new regulations that change the administration of resident representative offices of foreign enterprises in China. The new regulations require ROs of foreign enterprises to provide audited accounting information on a regular basis, prohibit them from conducting profitable activities, and specify the relative penalties for foreign enterprises that violate the rules. The “Regulations on the Administration of Registration of Resident Representative Offices of Foreign Enterprises” issued on November 19, 2010 will take effect on March 1, 2011; replacing the previous regulations that have been in force since 1983. The most noticeable changes in the new provision are listed below:
Additional increases in tax liabilities
Representative offices are also no longer exempt from corporate income tax in China. A circular issued by the State Administration of Taxation, Guoshuifa [2010] No. 18, issued on February 20, 2010, explicitly stipulates that ROs must pay corporate income tax on their taxable income, as well as sales tax and VAT, and will be required to assess CIT liability using either the cost plus method or actual revenue method. Under each method, the deemed profit margin shall be no less than 15 percent, an increase from the previous deemed profit margin of 10 percent. The effective date of these measures was January 1, 2010. This means that all of last year’s business activities are subject to this rule and that your annual audit – soon due – will specifically abide by these regulations. If your RO hasn’t previously paid tax, this year you may well be subject to a rude awakening and a substantial bill.
To deal with these new tax requirements, ROs should obtain the pertinent business registration documents (or the relevant department approval) from their local tax authorities. If the content of tax registration changes or there is an early termination of business activities, tax collection should be in accordance with law and relevant provisions of the declaration. ROs must provide valid accounting records in accordance with the relevant laws, administrative regulations, and the State Council’s new regulations as stated above. The new circular mentions that tax authorities have the right to penalize ROs providing incomplete or incorrect records. ROs should also perform the principles of actual functions in matching with potential risks, and accurately calculate their taxable income. If your RO has not already changed its accounting system, nor been paying CIT during 2010, the annual audit in April will come as a shock. ROs in such a position are urged to seek immediate professional advice to deal with this situation.
RO annual audits
Representative offices in China may also find themselves having to comply with China’s transfer pricing regulations for the first time in the upcoming annual audit period. China audits ROs (and all other foreign invested enterprises) each year on a calendar year basis, with a four month window to submit accounts for examination. This means that all ROs and other foreign investments must now start to prepare their accounts for the year 2010 and to have these fully prepared and audited by a third party CPA firm for submission no later than the end of April 2011. What is different about the circumstances for standard representative office audits this time around is that for the first time, China requires ROs to follow the principle of proportionate functions and risks when calculating its taxable income. This means that ROs should comply in transactions with its overseas head office on the arm’s length principle, under which relevant incomes, costs and expenditures should be accounted for at fair prices.
We suspect that for 2010 audits, of particular interest will be the chief representative’s salary as declared in China. Many CRs are resident in China, but maintain their salary payments as two separate incomes, one in China, the other back home. The Chinese authorities may well question this, as residency in China means the Chinese tax authorities possess the right to levy income tax on the full salary paid, regardless of whether that was met in China or not. Such circumstances may also lead to a reassessment of the total salary paid and declared in China, together with an upward assessment of both the individual income tax amount due in addition to the business tax payable by the representative office. If expatriate staff are engaging in such tactics, it is preferable for this issue to be addressed prior to the audit submission as tax treatments do exist that may assist with avoiding state imposed recalculations of tax due.
Other examinations concerning transfer pricing may come into effect if the representative office has any licensing or other agreements with its own parent; these may be subject to the “fair price” rule and again recalculated upwards. On these issues, China’s double tax agreements may well be worth studying for potential alleviation. Chief representatives of China ROs, together with other foreign employees splitting salary payments between China and home, may wish to take advice over this issue in addition of other potential areas of transfer pricing concern for representative offices. Solving such issues can take time, and with audits due to be filed by April, it is better to bring these matters to the attention of professional advisors at the pre-audit submission stage than face questioning and potentially additional tax imposition by the tax authorities once audit is submitted and found to be questionable. Negotiations after audit submission have little chance of success at this level, we recommend dealing with the issue, understanding any potential liabilities and discussing solutions some time prior to submission of the official audit.
Upgrading your RO
As we have seen, the future of the RO as a cheap way to set up a China presence and do business in the country is now coming to an end. Increased tax burdens, an inability to offset expenses against these, and restrictions on activities, staff and size are all taking a toll. Operating an RO as a trading company by using third party bank accounts will also come under scrutiny, and if caught, will inevitably lead to fines over unpaid income tax. Given that RO as a cheap option to conduct business in China are about to become extinct, what are the alternatives? Fortunately, China offers a way out. If you require your China operations to directly buy and sell, have its own import/export license, and legitimately trade in China – then you will need to change your current RO structure to that of a foreign invested commercial enterprise (FICE) or wholly foreign owned enterprise (WFOE) in order not to fall foul of the new regulatory and tax changes concerning the use of an RO.
Why change now?
There are five main reasons:
There are two procedures to carry out, which can be handled concurrently. First of all, the existing RO needs to go through its annual audit. This is a statutory obligation and you must go through this process. Audits need to be submitted by the end of April (sometimes an extension can be granted). At this juncture, the RO needs to settle up all taxes and all liabilities assessed. This can be carried out not just for the statutory requirement, but also with a view to closing the RO. Such closures also require an audit to be submitted as part of the closure process, using the annual audit to do this means you don’t have to be audited twice. The full closure procedure may take some time (up to 12 months) to complete, however, acceptance by the government of the closure audit then triggers the termination of the RO license, closure of bank accounts and so on, which then releases the foreign investor from ongoing tax and operational liabilities for the RO. This procedure can usually be enacted within three to four months from start to finish. It means it is effectively possible to get out of your RO structure and liabilities by April 2011 if you act now.
Concurrently with this, a new structure needs to be put in place. Whether this is a FICE or a WFOE depends upon the nature of the business activities, and whether you wish to expand them beyond the previous activities of the original RO structure.
Foreign invested commercial enterprises
These are typically used for the following business activities:
These are typically used for the following business activities:
WFOEs may also be used for manufacturing. In which case, what is now an RO may be upgraded to a fully-fledged manufacturing unit, lessening dependence upon Chinese suppliers and placing the entire manufacturing and sales operations under your control. Registered capital requirements are higher for manufacturing WFOEs than for services WFOEs, but may provide an option for some RO operations wishing to take advantage of the ability to sell directly to the China market. The trend is there – China is moving to a more consumer based economy and the government is committed to providing cheap credit and loans to domestic consumers to ensure this happens. Aside from services, the sale of products to the newly created class of Chinese domestic consumers is now very much a growth area and foreign investors should consider enhancing what is now an RO into either a FICE, a service WFOE, or a fully-fledged manufacturing and sales WFOE. The choices are all there. Your professional services firm will be able to advise on the suitable structure for you depending upon your specific needs. Your business strategy – what you want to accomplish – should determine the business structure.
It should be noted that the establishment of both a FICE and a WFOE are rather more complex than an RO, and should not be treated (as many consultants regrettably do) as pure licensing applications. As most FICE/WFOE will be involved in trade of some sort, considerations over VAT, customs and other issues that can affect the financial obligations of the business must be taken into consideration. These will add more to the legally required “minimum registered capital” and should be worked out in advance in order for you to both plan your business financing properly and to make it as tax efficient as possible. However, the minimum registered capital requirements are far less than they used to be. Essentially what now needs to be injected is the operational working capital – something that should be easy to evaluate for ROs that have already been operational. Upgrading from an RO to a FICE/WFOE in any event is a procedure of increasing operational efficiency, attention to detail should also be taken when structuring the new corporation to maximize financial and tax effectiveness upon the regulatory need to upgrade.
The structuring and application of the new FICE/WFOE can be combined at the same time as the RO closure. Staff and other assets may then be moved over to the new structure – possibly without even having to leave your premises (although a new lease in the name of the new company will need to be arranged). For other ROs, moving to a more appropriate FICE/WFOE structure provides a new lease of life to your China operations, as it permits legitimate trading, is now less expensive to run, and gives options over the accessibility of a vastly superior scope of business activities.
A new era for China investors
Although these changes may come as an unwelcome shock to some foreign businesses in China, in reality they move the legal basis for conducting trade activities in China to a more secure legal footing. FICE and WFOEs are legal persons in China; RO never were. In this case alone, protecting your China business by having it secure under China’s corporate laws is a more solid platform for protecting your interests and activities than a Representative Office. There are additional benefits in tax treatments; RO could never make a loss, whereas a limited liability company can do so. It makes far better sense to book expenses against income, again a capability RO never possessed.
The timing too, is right. As China shifts to a consumer economy, opportunities exist for foreign invested companies to take advantage of China’s new wealth creation and particpate in a new “golden era” of Chinese consumerism. There may never have been a better time to establish a FICE or WFOE in China. While old habits die hard, the RO is now largely outmoded, ineffective and unsuitable for most China investors. Upgrading your RO to a properly financed and licensed legal entity is a natural progression to take at this stage of SME corporate development in the PRC.
unquote
80% of the existing RO offices in China are operating in some kind of grey zone: Surely they conduct business & profits but all remote controlled by their HQ for example in Hong Kong. I know some competitors running RO in Shanghai they all have the same Hong Kong office address in Wyndham Street (no normal company can afford office rents there) - it is just an accounting company there doing the audit there for the HK IRD and the adress is used to issue invoices to oversea customers - even this invoices are typed in the Shanghai office on the Hong Kong letterhead. All this companies have no export rights in China - so normally at least some part of their shipping documents like Bill of Lading or Air Way Bill always shows another company name (mainly the name of the manufacturer). Careful if you deal with this kind of companies. One day they maybe suddenly are not there anymore.........
Jan. 14 – China has dramatically changed its regulations concerning the operation of representative offices (ROs) in the country and these alterations are due to take effect from March 1 this year. They will alter the operational and financial effectiveness of using ROs in China considerably.
ROs make up some 50 percent of all foreign presence in China and the implications to them of these changes are immediate and profound. SMEs in particular operating ROs in China will need to assess their operational usefulness in light of these developments, and consider making plans for alternative structures. In this piece we highlight the complete picture concerning these developments and provide suggestions and tips for handling and adapting to this far-reaching regulatory upheaval.
What the regulations say
The Chinese State Council issued new regulations that change the administration of resident representative offices of foreign enterprises in China. The new regulations require ROs of foreign enterprises to provide audited accounting information on a regular basis, prohibit them from conducting profitable activities, and specify the relative penalties for foreign enterprises that violate the rules. The “Regulations on the Administration of Registration of Resident Representative Offices of Foreign Enterprises” issued on November 19, 2010 will take effect on March 1, 2011; replacing the previous regulations that have been in force since 1983. The most noticeable changes in the new provision are listed below:
- The RO should submit an annual report between March 1 and June 30 every year providing information on the legal status and standing information of the foreign enterprise, ongoing business activities of the RO, and payment balance audited by their accounting agencies. The registration authorities will issue an RMB10,000 to RMB30,000 penalty if the RO fails to provide such reports on time, and an RMB20,000 to RMB200,000 penalty if the report includes false information. Fraud may also lead to license revocation;
- The RO cannot engage in any profit activities except for those activities which China has agreed on in international agreements or treaties. The activities ROs can be involved in include market research, display and publicity activities that relate to company products or services, contact activities that relate to company product or service sales, domestic procurement and investment. ROs will be subject to penalties of RMB50,000 to RMB200,000 for each profit activity involvement, and RMB10,000 to RMB100,000 for exceeding the permitted business scope mentioned above;
- Foreign enterprises should announce to the public through media designated by the authorities when they establish new ROs or make any changes to them; the Chinese registration authorities will also make announcements when they revoke the license of an RO or cancel an RO establishment. ROs that fail to make such announcements may pay an RMB10,000 to RMB30,000 penalty
Additional increases in tax liabilities
Representative offices are also no longer exempt from corporate income tax in China. A circular issued by the State Administration of Taxation, Guoshuifa [2010] No. 18, issued on February 20, 2010, explicitly stipulates that ROs must pay corporate income tax on their taxable income, as well as sales tax and VAT, and will be required to assess CIT liability using either the cost plus method or actual revenue method. Under each method, the deemed profit margin shall be no less than 15 percent, an increase from the previous deemed profit margin of 10 percent. The effective date of these measures was January 1, 2010. This means that all of last year’s business activities are subject to this rule and that your annual audit – soon due – will specifically abide by these regulations. If your RO hasn’t previously paid tax, this year you may well be subject to a rude awakening and a substantial bill.
To deal with these new tax requirements, ROs should obtain the pertinent business registration documents (or the relevant department approval) from their local tax authorities. If the content of tax registration changes or there is an early termination of business activities, tax collection should be in accordance with law and relevant provisions of the declaration. ROs must provide valid accounting records in accordance with the relevant laws, administrative regulations, and the State Council’s new regulations as stated above. The new circular mentions that tax authorities have the right to penalize ROs providing incomplete or incorrect records. ROs should also perform the principles of actual functions in matching with potential risks, and accurately calculate their taxable income. If your RO has not already changed its accounting system, nor been paying CIT during 2010, the annual audit in April will come as a shock. ROs in such a position are urged to seek immediate professional advice to deal with this situation.
RO annual audits
Representative offices in China may also find themselves having to comply with China’s transfer pricing regulations for the first time in the upcoming annual audit period. China audits ROs (and all other foreign invested enterprises) each year on a calendar year basis, with a four month window to submit accounts for examination. This means that all ROs and other foreign investments must now start to prepare their accounts for the year 2010 and to have these fully prepared and audited by a third party CPA firm for submission no later than the end of April 2011. What is different about the circumstances for standard representative office audits this time around is that for the first time, China requires ROs to follow the principle of proportionate functions and risks when calculating its taxable income. This means that ROs should comply in transactions with its overseas head office on the arm’s length principle, under which relevant incomes, costs and expenditures should be accounted for at fair prices.
We suspect that for 2010 audits, of particular interest will be the chief representative’s salary as declared in China. Many CRs are resident in China, but maintain their salary payments as two separate incomes, one in China, the other back home. The Chinese authorities may well question this, as residency in China means the Chinese tax authorities possess the right to levy income tax on the full salary paid, regardless of whether that was met in China or not. Such circumstances may also lead to a reassessment of the total salary paid and declared in China, together with an upward assessment of both the individual income tax amount due in addition to the business tax payable by the representative office. If expatriate staff are engaging in such tactics, it is preferable for this issue to be addressed prior to the audit submission as tax treatments do exist that may assist with avoiding state imposed recalculations of tax due.
Other examinations concerning transfer pricing may come into effect if the representative office has any licensing or other agreements with its own parent; these may be subject to the “fair price” rule and again recalculated upwards. On these issues, China’s double tax agreements may well be worth studying for potential alleviation. Chief representatives of China ROs, together with other foreign employees splitting salary payments between China and home, may wish to take advice over this issue in addition of other potential areas of transfer pricing concern for representative offices. Solving such issues can take time, and with audits due to be filed by April, it is better to bring these matters to the attention of professional advisors at the pre-audit submission stage than face questioning and potentially additional tax imposition by the tax authorities once audit is submitted and found to be questionable. Negotiations after audit submission have little chance of success at this level, we recommend dealing with the issue, understanding any potential liabilities and discussing solutions some time prior to submission of the official audit.
Upgrading your RO
As we have seen, the future of the RO as a cheap way to set up a China presence and do business in the country is now coming to an end. Increased tax burdens, an inability to offset expenses against these, and restrictions on activities, staff and size are all taking a toll. Operating an RO as a trading company by using third party bank accounts will also come under scrutiny, and if caught, will inevitably lead to fines over unpaid income tax. Given that RO as a cheap option to conduct business in China are about to become extinct, what are the alternatives? Fortunately, China offers a way out. If you require your China operations to directly buy and sell, have its own import/export license, and legitimately trade in China – then you will need to change your current RO structure to that of a foreign invested commercial enterprise (FICE) or wholly foreign owned enterprise (WFOE) in order not to fall foul of the new regulatory and tax changes concerning the use of an RO.
Why change now?
There are five main reasons:
- China is now clamping down on the use of ROs for trading activities and has issued directives effectively banning this
- ROs are now more expensive to operate than a FICE or WFOE as they cannot offset operational trading costs against CIT
- The alternative structures of FICE and WFOE are now relatively inexpensive to set up
- To close an RO requires an audit. 2010 audits are due and ROs have to submit audits for the year’s activities in any event. You can use your annual audit as the base for your RO closure and move to a FICE/WFOE structure without the need to go through a second audit for closure
- FICE and WFOE also have tax advantages, especially as concerns the ability to reclaim and offset VAT, and book profits/losses, which ROs are not able to do
There are two procedures to carry out, which can be handled concurrently. First of all, the existing RO needs to go through its annual audit. This is a statutory obligation and you must go through this process. Audits need to be submitted by the end of April (sometimes an extension can be granted). At this juncture, the RO needs to settle up all taxes and all liabilities assessed. This can be carried out not just for the statutory requirement, but also with a view to closing the RO. Such closures also require an audit to be submitted as part of the closure process, using the annual audit to do this means you don’t have to be audited twice. The full closure procedure may take some time (up to 12 months) to complete, however, acceptance by the government of the closure audit then triggers the termination of the RO license, closure of bank accounts and so on, which then releases the foreign investor from ongoing tax and operational liabilities for the RO. This procedure can usually be enacted within three to four months from start to finish. It means it is effectively possible to get out of your RO structure and liabilities by April 2011 if you act now.
Concurrently with this, a new structure needs to be put in place. Whether this is a FICE or a WFOE depends upon the nature of the business activities, and whether you wish to expand them beyond the previous activities of the original RO structure.
Foreign invested commercial enterprises
These are typically used for the following business activities:
- Import-export and distribution
- Retailing: selling goods and related services to individuals from a fixed location, in addition to TV, telephone, mail order, internet and vending machines,
- Wholesaling: selling goods and related services to companies and industry, trade or other organizations
- Agencies, brokerages: representative transactions on the basis of provisions
- Franchising
These are typically used for the following business activities:
- Consulting, other professional services
- Quality control, after sales services, product design, technical support, sampling (although minimum amount regulations apply)
WFOEs may also be used for manufacturing. In which case, what is now an RO may be upgraded to a fully-fledged manufacturing unit, lessening dependence upon Chinese suppliers and placing the entire manufacturing and sales operations under your control. Registered capital requirements are higher for manufacturing WFOEs than for services WFOEs, but may provide an option for some RO operations wishing to take advantage of the ability to sell directly to the China market. The trend is there – China is moving to a more consumer based economy and the government is committed to providing cheap credit and loans to domestic consumers to ensure this happens. Aside from services, the sale of products to the newly created class of Chinese domestic consumers is now very much a growth area and foreign investors should consider enhancing what is now an RO into either a FICE, a service WFOE, or a fully-fledged manufacturing and sales WFOE. The choices are all there. Your professional services firm will be able to advise on the suitable structure for you depending upon your specific needs. Your business strategy – what you want to accomplish – should determine the business structure.
It should be noted that the establishment of both a FICE and a WFOE are rather more complex than an RO, and should not be treated (as many consultants regrettably do) as pure licensing applications. As most FICE/WFOE will be involved in trade of some sort, considerations over VAT, customs and other issues that can affect the financial obligations of the business must be taken into consideration. These will add more to the legally required “minimum registered capital” and should be worked out in advance in order for you to both plan your business financing properly and to make it as tax efficient as possible. However, the minimum registered capital requirements are far less than they used to be. Essentially what now needs to be injected is the operational working capital – something that should be easy to evaluate for ROs that have already been operational. Upgrading from an RO to a FICE/WFOE in any event is a procedure of increasing operational efficiency, attention to detail should also be taken when structuring the new corporation to maximize financial and tax effectiveness upon the regulatory need to upgrade.
The structuring and application of the new FICE/WFOE can be combined at the same time as the RO closure. Staff and other assets may then be moved over to the new structure – possibly without even having to leave your premises (although a new lease in the name of the new company will need to be arranged). For other ROs, moving to a more appropriate FICE/WFOE structure provides a new lease of life to your China operations, as it permits legitimate trading, is now less expensive to run, and gives options over the accessibility of a vastly superior scope of business activities.
A new era for China investors
Although these changes may come as an unwelcome shock to some foreign businesses in China, in reality they move the legal basis for conducting trade activities in China to a more secure legal footing. FICE and WFOEs are legal persons in China; RO never were. In this case alone, protecting your China business by having it secure under China’s corporate laws is a more solid platform for protecting your interests and activities than a Representative Office. There are additional benefits in tax treatments; RO could never make a loss, whereas a limited liability company can do so. It makes far better sense to book expenses against income, again a capability RO never possessed.
The timing too, is right. As China shifts to a consumer economy, opportunities exist for foreign invested companies to take advantage of China’s new wealth creation and particpate in a new “golden era” of Chinese consumerism. There may never have been a better time to establish a FICE or WFOE in China. While old habits die hard, the RO is now largely outmoded, ineffective and unsuitable for most China investors. Upgrading your RO to a properly financed and licensed legal entity is a natural progression to take at this stage of SME corporate development in the PRC.
unquote
80% of the existing RO offices in China are operating in some kind of grey zone: Surely they conduct business & profits but all remote controlled by their HQ for example in Hong Kong. I know some competitors running RO in Shanghai they all have the same Hong Kong office address in Wyndham Street (no normal company can afford office rents there) - it is just an accounting company there doing the audit there for the HK IRD and the adress is used to issue invoices to oversea customers - even this invoices are typed in the Shanghai office on the Hong Kong letterhead. All this companies have no export rights in China - so normally at least some part of their shipping documents like Bill of Lading or Air Way Bill always shows another company name (mainly the name of the manufacturer). Careful if you deal with this kind of companies. One day they maybe suddenly are not there anymore.........
